Let the consumption function be given by C = 80 + 0.9YDP with permanent disposable income specified according to YDP = 0.5YD + 0.3YD-1) + 0.2YD-2). Two years after a permanent increase in income of $1,000, consumption will have increased by
A) $1,000.
B) $900.
C) $800.
D) $720.
E) $80.

Question

Quizplus · Accepted Answer

The consumption function C = 80 + 0.9YDP shows that for every dollar increase in permanent disposable income (YDP), consumption increases by 90 cents ($0.9). The formula for YDP = 0.5YD + 0.3YD-1 + 0.2YD-2 indicates how current and past incomes are weighted to calculate permanent income. A permanent increase in income of $1,000 affects YDP as follows: in the first year, YDP increases by $500 (0.5 of $1,000), in the second year by an additional $300 (0.3 of $1,000), and in the third year by an additional $200 (0.2 of $1,000), totaling a $1,000 increase in YDP over three years. However, two years after the increase, the total increase in YDP is $800 ($500 from the first year plus $300 from the second year). Since consumption increases by 90% of the change in YDP, the increase in consumption is 0.9 * $800 = $720.

Let the Consumption Function Be Given by C = 80